Tranches: How They Work, Risks and Role in the Financial Crisis

How They Created Both the Housing Boom and Bust

tranches
••• Banks repackaged debt into tranches of bundles they could resell. Photo: Michael A. Keller/Fuse Fuse

A tranche is a slice of a bundle of loans. It allows you to invest in the portion with similar risks and rewards. Tranche is the French word for slice. 

Banks bundle mortgages to resell them on the secondary market. That's called a mortgage-backed security. Most bundles consisted of adjustable-rate mortgages. Each mortgage has different interest rates at different times. The borrower pays a "teaser" low-interest rates for the first three years and higher rates after that.

The risk of default is small during the first three years since the rates are low.  After that, the risk of default is higher. That's because the rates go up, making it more expensive. Also, many borrowers expect to either sell the house or refinance by the fourth year.

Some MBS buyers would rather have the lower risk and lower rate. Others would rather have the higher rate in return for the higher risk. Banks sliced the securities into tranches to meet these different investor needs. They resold the low-risk years in a low-rate tranche, and the high-risk years in a high-rate tranche. A single mortgage could be spread across several tranches.

Examples

The movie The Big Short gives entertaining examples of how tranches work as a Jenga game. It explains how the Brownfield Fund made money by shorting AA tranches of MBS.

History

In the 1970s,  Fannie Mae and Freddie Mac created mortgage-backed securities.

First, they bought the loans from the bank. That freed the bank to make more investments and allowed more people to become homeowners.

In 1999, the safe and predictable world of banking changed forever. Congress repealed the Glass-Steagall Act. Suddenly, banks could own hedge funds and invest in sophisticated derivatives.

In a competitive banking industry,  those with the complex financial products made the most money. They bought out smaller, stodgier banks. Financial services and housing drove U.S. economic growth until 2007.

de its value. It's a financial product whose value is loosely based on the value of the mortgages that backed the security. That value was determined by a computer model.

The college graduates who developed these computer models were known as quant jocks. They wrote the computer programs that determined the value of the mortgage-backed security.

The market rewarded banks who made the most sophisticated financial products. The banks compensate the quant jocks who designed the most sophisticated computer models. They divided the mortgage-backed security into specific tranches. They tailored each tranche to the different rates in an adjustable-rate mortgage. The securities became so complicated that buyers couldn't determine their underlying worth. Instead, they relied on their relationship with the bank selling the tranche. The bank relied on the quant jock and the computer model.

Risks

The assumption underlying all computer models was that housing prices always went up. That was a safe assumption until 2006.

When home prices fell, so did the the value of the tranches, the mortgage-backed security, and the economy.

When housing prices plummeted, no one knew the value of the tranches. It meant no one could price the mortgage-backed security.

The secondary market freed banks from collecting on the mortgages when they become due. They had sold them to other investors. As a result, the banks weren't disciplined in sticking to sound lending standards. They made loans to borrowers with poor credit scores. These subprime mortgages were bundled up and resold as part of a high-interest tranche. Investors who wanted more return snapped them up. In the drive to make a high profit, they didn't realize there was a good chance the loan wouldn't be repaid. The credit rating agencies, like Standard & Poor's, made things worse.

They rated some of these tranches AAA, even though they had sub-prime mortgages in them.

Investors were also lulled by buying guarantees, called credit default swaps. Reliable insurance companies, like AIG, sold the insurance on the risky tranches just like any other insurance product. But AIG didn't take into account that all the mortgages would go south at the same time. The insurer didn't have the cash on hand to pay off all the credit default swaps. The Federal Reserve bailed it out to keep it from going bankrupt.